What Is the 2% Rule?
The 2% rule is an investing strategy where an investor risks no more than 2% of their available capital on any single trade. To implement the 2% rule,theinvestor first must calculate what 2% of their available trading capital is: this is referred to as the capital at risk (CaR). Brokerage fees for buying and selling shares should be factored into the calculation in order to determine the maximum permissible amount of capital to risk. The maximum permissible risk is then divided by the stop-loss amount to determine the number of shares that can be purchased.
Key Takeaways
- The 2% rule is an investing strategy where an investor risks no more than 2% of their available capital on any single trade.
- To apply the 2% rule, an investor must first determine their available capital, taking into account any future fees or commissions that may arise from trading.
- Stop-loss orders can be implemented to maintain the 2% rule risk threshold as market conditions change.
How the 2% Rule Works
The 2% rule is a restriction that investors impose on their trading activities in order to stay within specified risk management parameters. For example, an investor who uses the 2% rule and has a $100,000 trading account, risks no more than $2,000–or 2% of the value of the account–on a particular investment. By knowing what percentage of investment capital may be risked, the investor can workbackward to determine the total number of shares topurchase. The investorcan also use stop-loss orders to limit downside risk.
In the event that market conditions change, an investor may implement a stop order to limit their downside exposure to a loss that only represents 2% of their total trading capital. Even if a trader experiences ten consecutive losses, using this investment strategy, theywill only draw their account down by 20%. The 2% rule can be used in combination with other risk management strategies to help preserve a trader’s capital. For instance, an investor may stop trading for the month if the maximum permissible amount of capital they are willing to risk has been met.
Using the 2% Rule with a Stop Loss Order
Suppose that a trader has a $50,000 trading account and wants to trade Apple, Inc. (AAPL). Using the 2% rule, the trader can risk $1,000 of capital ($50,000 x 0.02%). If AAPL is trading at $170 and the trader wants to use a $15 stop loss, they can buy 67 shares ($1,000 / $15).If there is a $25 round-turn commission charge, the trader can buy 65 shares ($975 / $15).
In practice, traders must also consider slippage costs and gap risk. These can result in events that make the potential for loss significantly greater than 2%. For instance, if the trader held the AAPL position overnight and it opened at $140 the following day after an earnings announcement, this would result in a 4% loss ($1,000 / $30).
